Magazine

Why The Dollar Is Blooming Again

July 03, 2005

What has gotten into the dollar? For the past three years the greenback has been in a funk against just about every major currency on the planet. Mounting gloom over America's trade deficit, economic growth, and even the war on terrorism preoccupied currency traders. But in the past few months the dollar has been confounding forecasters -- and whipsawing short-sellers -- by rebounding sharply. Goldman, Sachs & Co. (GS) took the unusual step on June 13 of changing its near-term currency outlook for the second time in less than a month to jump on the dollar bullwagon. It is projecting that the buck will appreciate to $1.15 against the euro and 110 yen by mid-September, from the $1.20 and 108 yen it projected initially. It now trades at $1.21 to the euro and 108.94 yen.

So far this year the dollar has gained 5.3% against the British pound, 6.1% against the yen, and 11.8% vs. the euro. What's more, there are few signs that it will give up its recent gains soon. "There has been a seismic shift in thinking about the dollar," says James McCormick, London-based global head of foreign exchange research at Lehman Brothers Inc. (LEH)

Some of the U.S. currency's newfound strength is a reaction to the faltering euro, which has been hit not just by doubts about the health of the euro zone but about the viability of the single currency itself. Europe's doldrums -- euro zone growth is projected to top out at 1.6% this year -- have rekindled a long-smoldering debate about whether the European Central Bank needs to cut interest rates. The ECB has resisted those calls, but if it reconsiders, an interest-rate drop would have a negative impact on the euro. And while French and Dutch voters' recent rejection of the European Union constitution was widely expected, it drew attention to the policy discord at the core of the EU. A few politicians, particularly in Italy, have even dared to suggest that the one-size-fits-all nature of the euro is the problem. Although no one expects the euro to collapse, the debate is contributing to an uncertain atmosphere in foreign-exchange trading pits.

Meanwhile, Japan's hide-and-seek recovery has done nothing to strengthen the yen. "Although the economic data are improving, people have basically been disappointed with Japan," says Paul Sheard, an economist at Lehman Brothers in Tokyo. "The Bank of Japan has been in an almost continuous easing mode for 14 or 15 years."

BUYING AMERICAN

Compared with Japan and much of Europe, prospects in the U.S. look positively balmy, with growth expected to hit 3.6% this year. While inflation remains low, Federal Reserve Bank Chairman Alan Greenspan has been signaling that more rate hikes are in the offing. The upshot is a widening differential in bond yields. The U.S.'s historically paltry 4% yields on 10-year notes are generous compared with yields of 3.1% in Europe and 1.3% in Japan for similar issues. That's attracting investment in Treasuries and other securities -- and buoying the dollar.

Plus, foreign money washing onto American shores continues to underwrite the U.S. current account deficit, which last year was $668 billion, or 5.7% of GDP. Many see a looming dollar crash in that number, but in fact the balance-of-payments crisis could be getting less critical. March and April trade data were better than expected, with the deficit well below the high levels of January and February. That has led to talk of a leveling out -- another boon to the dollar. "It is still early days, but the recent data [do] suggest that the U.S. trade deficit may be stabilizing," Goldman Sachs noted in its recent report.

Better yet for dollar bulls, the U.S. government's fiscal deficit is also coming in much lower than last year's $412 billion, or 3.5% of GDP, thanks to increased tax revenue and slower spending. "The U.S. fiscal situation is improving for the first time in several years, and that is playing a role in the psyche around the dollar," says Lehman's McCormick.

Of course, sentiment in the currency markets is notoriously fickle. An expected revaluation of the Chinese yuan later this year, for instance, could trigger wider appreciation in Asian currencies, including the yen. And if euro zone GDP starts to stir even a little, dollar holders could head for the exits. But for this summer, at least, the dollar is having fun in the sun.